Why PPPs may offer poor value for money

Article by Richard Wellings in Public Sector Executive

For several decades the British economy has been hampered by the poor quality of its infrastructure. Whether in transport, education or health, investment has typically been low by international standards and levels of service have suffered as a result.

Public-private partnerships (PPPs) seemed to offer a solution to this problem. Private capital would be used to fund much-needed projects. Better still, private companies could build and operate the new infrastructure, bringing, it was hoped, huge cost savings.

New investment could be detached from the purse strings of the Treasury. It would no longer be so dependent on the short-term imperatives of the public finances. And because the money was borrowed privately, there was no need, at least initially, to count it as public debt.

Moreover, contracts could be written to incentivise firms to complete schemes on time and on budget. The main pitfalls of public-sector procurement - the delays and mammoth cost overruns - could be avoided.

The first modern PPPs were began in the 1980s under what became known as the Private Finance Initiative (PFI). Their numbers grew during the early-mid 1990s, with several design, build, finance and operate (DBFO) road schemes, as well as the construction of a number of privately-operated prisons. These projects were generally viewed as successful within government - a higher proportion were delivered on time and on budget than would have been expected using traditional procurement methods.

Building on these foundations, the election of a New Labour government saw a rapid expansion in the number of PPPs. The model fitted well with Labour’s ‘Third-Way’ approach to the economy. Instead of outright nationalisation, with its well-documented ineffiencies, the dynamism of the private sector would be harnessed for social objectives.

By 2003/04 PPP schemes accounted for 39% of capital spending by UK government departments. And by January 2008 there were over 500 operational PPP projects with a total capital value of around £44 billion and a further number in the pipeline. Their scope was also widened, with a higher proportion used to build new schools and hospitals. Public transport became a major investment priority rather than roads.

However, a new study from the Institute of Economic Affairs* suggests that this huge expansion of PPPs may have been misguided. Indeed, it was arguably when partnerships started to go wrong. In particular, unlike the earlier schemes, the new projects were more likely to be in fields marked by a high level of political sensitivity.

A good example is the London Underground PPP. This huge project, designed to upgrade the Tube, required an annual subsidy of £1 billion. Fiercely resisted by the Greater London Authority under Ken Livingstone, who favoured an alternative bond finance scheme, it was imposed on the capital by central government with heavy Treasury backing. So even before it started the process was marked by a high level of controversy.

Extremely complex 30-year contracts were drawn up, at a cost of £455 million in consultancy fees, and the Rail Regulator was appointed as ‘PPP Arbiter’ to adjudicate any disputes. Two consortiums were selected to upgrade and maintain different sections of the network.

In 2003 the Metronet consortium began a £17 billion project covering nine out of twelve tube lines. It soon got into difficulties. In April 2004 it was fined £11 million for poor performance, but this was just the start.

Further fines followed and in June 2007 Metronet, concerned about cost escalation, requested an extraordinary review by the PPP Arbiter. A short-term cost overrun of £551 million was predicted, rising to £2 billion by 2010, and this was blamed on additional demands made by Transport for London.

But the Arbiter had a different view – most of the cost escalation could be explained by Metronet’s inefficiency and only a small fraction of the requested extra payments would be forthcoming. Faced with huge losses, the company went into administration.

The government tried to find private bidders for the Metronet contracts but failed – unsurprisingly given the uncertainty concerning costs. The public sector then became responsible for the upgrades and maintenance. Taxpayers would now pick up the bill for any cost overruns.

These events seemed to illustrate a key potential weakness of PPPs. When they involve essential infrastructure that government will not allow to fail, it is clear that a high proportion of a project’s risk remains with the public sector.

Yet acknowledging this undermines one of the key rationales for PPPs, that they are good value for money despite apparently higher financing costs, because of their ability to transfer risk to private investors.

Serious problems have also been evident in the National Health Service (NHS). There has been a huge hospital rebuilding programme over the last 12 years, with 90% of its £12 billion cost privately financed.

While there has been a welcome improvement in the quality of the infrastructure, the long-term charges resulting from the PPP schemes are now causing significant financial difficulties for many NHS trusts. In part this reflects the higher direct costs of private finance. For example, typical interest rates have been around 8%, compared with 4.5% with public finance.

In 2005/06, 50% of trusts with large PPP projects (capital value £50 million or higher) were in deficit, compared with an average of 23%. Such trusts were also more likely to have been placed in ‘special measures’ by the Department of Health.

There is also strong evidence that the ongoing cost of PPPs is forcing trusts to reduce capacity elsewhere, for example, by reducing staff numbers and the number of beds, as well as downgrading the functions of smaller hospitals. Unfortunately this is likely to have a negative effect on patient care.

The experience to date therefore suggests that PPP schemes have failed to live up to their early promise. There are several explanations.

Firstly, comparisons with public finance may understate the true cost of government funding. While it may be possible to borrow at low interest rates this is only because potential risks and losses have been offloaded on to taxpayers.

Secondly, a high proportion of recent PPPs have been plagued by high ‘transaction costs’. They have involved tortuous bidding processes and the creation of complex contractual agreements and regulatory frameworks, which have created additional costs and risks for the private-sector partners involved. Value for money has been reduced as a result.

Finally, the operation and outputs of PPP schemes have often been subject to substantial political and bureaucratic intervention. As seen with some of the public transport PPPs, a hostile relationship may develop between the counterparties. There can even be politically-motivated attempts to subvert the viability of projects. This makes it more difficult both to raise private finance and transfer risk. Investors are more likely demand a premium and contractual guarantees if they perceive political risks as high.

Accordingly, PPPs may not be a suitable funding model for some projects. The risks are particularly high in situations when government is unwilling to take a ‘hands-off’ approach. At the same time, if government will stand aside, perhaps after setting a loose regulatory framework, then depoliticisation through full-blooded privatisation may be the best option.

Dr Richard Wellings is Deputy Editorial Director at the Institute of Economic Affairs.

Further reading:
Public-Private Partnerships
, edited by David Parker, Economic Affairs, 29.1, £7.50.

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